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NC State Economist
C O L L E G E O F A G R I C U L T U R E & L I F E S C I E N C E S
North Carolina Cooperative Extension Service
Employment and program opportunities are offered to all people regardless of race, color, national origin, sex, age, or disability.
North Carolina State University, North Carolina A& T State University, U. S. Department of Agriculture, and local governments cooperating.
Agricultural and Resource Economics • September/ October 1999
Managing Risk
Geoff Benson, Ph. D.
Associate Professor and Extension Economist
Introduction
Farming is and will always be a risky business.
As farm businesses have become larger, risk
exposure levels have increased significantly. This
is due to bigger investments, greater debt, and a
growing dependence on purchased inputs. Changes
in farm programs and trade policy have a direct
impact on farm businesses. New technology
frequently favors larger farms, which is one reason
farm numbers have declined. Moreover, new
technology may not always perform as advertised
or may not be profitable. Plus, the application of
new technology frequently demands sophisticated
management skills. All of these factors create
extraordinary demands on the managers of modern
farm businesses. How can a manager cope?
There is a time- tested approach that managers
can follow to enhance their chances of success.
This technique includes setting clear goals, careful
planning, possessing or obtaining the resources and
skills needed to implement the plan, and systemati-cally
monitoring and evaluating farm performance.
Monitoring and evaluating farm performance and
taking corrective actions when needed are some-times
referred to as controlling the business.
Planning, implementing, and controlling are the
three broad functions of management. Risk
management is an important component of the
planning and implementing functions.
If the manager of a business is to control risk,
he or she must have ( or must develop) a broad
awareness and understanding of risk and risk
management as well as an appreciation of the value
of incorporating risk management into the
planning and decision- making process. Risk
management includes an understanding of
sources of risk and the ability to evaluate the
impact of specific risks, the capability to set risk
management priorities, an understanding of risk
management strategies and decision- making
tools, and the ability to develop and implement
plans to manage specific risks.
Sources of Risk
Describing and categorizing risks in a mean-ingful
way can help a manager develop an
understanding of the sources of risk, which is
essential in the development of effective risk
management strategies. There are five funda-mental
sources of risk:
( 1) Weather and other natural phenomena.
Local weather affects yields and quality, both
directly through temperature and precipitation
and indirectly through impacts on pest popula-tions.
Global weather affects world production
and prices. Weather and other natural phenom-ena
can cause many types of natural disasters.
( 2) Technology. Technology is embodied in farm
operating inputs, for example, seeds and pest
control products and capital assets such as
machinery and buildings. The performance of
existing technology is not known with certainty.
The performance of new innovations is even
S T A T E U N I V E R S I T Y
A & T S T A T E U N I V E R S I T Y
C O O P E R A T I V E
E X T E N S I O N
H e l p i n g P e o p l e P u t K n o w l e d g e t o W o r k
N C
2 NC State Economist
more uncertain but, once established, may render
current farm practices and assets obsolete. Early
adopters of new technology take more risks because
new technology may not work under certain condi-tions
or may not be profitable. However, when new
technology is profitable, the early adopters earn the
greatest rewards.
( 3) Social attitudes. The attitudes and preferences of
society as a whole affect the demand for farm prod-ucts
directly, and indirectly they influence the many
and diverse government policies and regulations that
affect the agricultural economy.
( 4) Institutions. This encompasses a wide array of
government policies and regulations, the legal frame-work
of society and business, and industry structure
and performance. Government policies are pervasive
and include farm, trade, macroeconomic, and environ-mental
policies. Health and safety policies and
regulations affect productivity and cost. Laws
determine or influence business and economic behav-ior
by defining what is legal and what is criminal
activity, and laws affect business incentives and
opportunities.
( 5) Individual human behavior. This category
includes the skill level and knowledge of the primary
operator as well as key employees. It considers the
family situation ( health, personal relationships, etc.)
and also the behavior of third parties ( failure to fulfill
business contracts, negligence, criminal acts, etc.).
The sources of risk described above affect the
financial performance of the farm in a variety of
ways. These include impacts on production, prices,
profits, cash flow, and asset values. Farm profit is
defined as farm revenue less all economic costs. A
farm business must be profitable to prosper and
survive. Cash flow feasibility is the ability of the farm
business to meet its financial obligations in a timely
manner. This includes paying bills, making debt
payments and providing cash for family living needs.
Asset values affect the solvency of the business and
the ability to obtain credit.
If risks are to be controlled, the manager must
consider both the probability of an undesirable event
occurring and the nature and size of the impacts that
an event would cause if it did occur.
Setting Risk Management Priorities
Risk has two components: ( 1) the chance or
probability that an unfavorable event will occur, and
( 2) the impact of that event if it does occur. A
comprehensive approach to risk management means
assessing the potential impacts of the multitude of
risks faced by the business and then addressing these
risks in some order based on importance or signifi-cance.
Some risks have a low probability of occur-ring
and would have a small impact if they did occur.
Others may have a higher probability and a much
larger potential impact on the business.
To assess the financial consequences of various
risks on the viability of the business and the achieve-ment
of business and family goals, the manager must
have a sound grasp of the financial performance and
status of the business, which includes solvency,
profitability and cash flow.
Risk Management Strategies
The third component of risk management includes
strategies and tools for deciding what action to take to
manage a specific risk. There are three basic strate-gies:
( 1) Reduce the probability of an unfavorable event.
( 2) Self- insure and accept the impact if an unfavor-able
event occurs.
( 3) Reduce the impact on the business if an unfavor-able
event occurs by shifting risk to others.
Each category includes a large number of specific
actions to consider.
Reducing the probability of an unfavorable event
can be accomplished by effective strategic planning.
In particular, managers can develop their management
skills and increase their knowledge base either
directly through self- improvement or indirectly by
using outside advisors. Examples of effective strate-gic
planning include a thorough understanding of the
external environment within which the business
operates and of the trends and forces that could
change this operating environment in the future; an
understanding of the management process and of the
production processes of the enterprises that comprise
the business. ( This includes understanding past farm
performance, both physically and financially, and
September/ October 1999 3
knowledge of the current financial status of the
business. It also includes knowledge of the histori-cal
variability of key factors, such as yields and
prices.); skill development, which runs the gamut
from production skills through labor and financial
management.
All of these activities impose costs in the form
of time spent ( opportunity costs) and money.
Self- insurance includes the following options:
· Modify revenue- related risks by diversifying
the enterprise mix. However, this may lead to
lower average revenue or added costs through a
loss of efficiency.
· Reduce production risk by spreading production
geographically. This option is likely to cause costs
of production to increase.
· Build net worth. This will help a business
survive adverse events, but may also mean forego-ing
credit financed business opportunities or
reducing family living withdrawals.
· Build excess production capacity to reduce the
likelihood that production- related activities will be
delayed, reducing yields. This adds to costs,
including added investments in oversize or back- up
equipment and carrying extra labor.
· Establish a form of asset ownership and busi-ness
organization that optimally minimizes the
impact of adverse outcomes. This includes deci-sions
about leasing versus owning farm assets, the
proportions of equity and debt capital invested in
the business, and the legal basis of the business
organization.
Reducing the impact by risk transfer includes
buying insurance of one form or another including
indemnity insurance, life insurance, and multi- peril
crop insurance. Costs are incurred in the form of
insurance premiums. Hedging, options, forward
contracting, etc. can reduce price risk; but manage-ment
time is required, and there are transactions
costs.
For any given risk, there may be more than one
risk management strategy. In fact, there may be
several options under each strategy. The cost and
effectiveness of each option may be different, so
benefits and costs must be weighed. Furthermore,
the financial status and performance of the busi-ness
affects the choice of strategy. Decision
criteria and tools are needed to evaluate alternative
risk- management options. Many tools are available
such as sensitivity analysis, payoff matrices, risk- rated
returns, decision grids, and contingency planning.
Implementation
Most farmers have extensive experience implement-ing
the production part of a business plan. This includes
acquiring the resources called for in the plan — land,
facilities, equipment, and working capital. Implementa-tion
also consists of acquiring and managing human
resources, both hired employees and family. Imple-menting
a risk- management plan requires information
and skills in various areas such as production, market-ing,
financial, institutional, and human resource risk.
Evaluating and making timely decisions about specific
risks takes time and may be a continuous process, for
example, tracking market developments when using
futures to manage price risk.
Self- management is also necessary. It includes
taking the time to manage and develop all the skills
required of a manager including information manage-ment
and effective problem solving. An assessment of
past business performance, knowledge and skills
relative to managers of similar businesses may help an
individual manager determine his or her strengths and
weaknesses. This, in turn, may suggest areas where
professional development would be helpful, or where
assistance from outside professionals is required.
Controlling
Controlling is the third area of management. It
consists of monitoring farm performance and evaluat-ing
results against clearly defined standards or targets.
Evaluating performance regularly allows a manager to
identify problems early and take corrective action.
Minor problems may be easy to solve with a little fine-tuning,
but larger problems may require major changes.
Effective monitoring requires timely information
from a record keeping system designed specifically for
this purpose. The targets can be production related, for
example, per acre yields, animal growth rates or feed
conversion rates. Then again they may be financial,
such as prices received, cost of production per bushel,
return on investment, or income generated for family
living. Monitoring financial performance such as debt-
NC State Economist
North Carolina Cooperative Extension Service
North Carolina State University
Agricultural and Resource Economics
Box 8109
Raleigh, North Carolina 27695- 8109
4
NON- PROFIT ORG.
U. S. POSTAGE
PAID
RALEIGH, NC
PERMIT # 2353
N. C. State Economist
Published bi- monthly by the Department of Agricul-ture
and Resource Economics and the Cooperative
Extension Service. Address correspondence to:
The Editor, N. C. State Economist
Box 8109, N. C. State University
Raleigh, NC 27695- 8109
The N. C. State Economist is now on- line at:
http:// www2. ncsu. edu/ ncsu/ cals/ ag_ rec/
virtual_ library. html
to- asset ratios, net worth trends and cash flows will
show changes in the financial status of the business and
its ability to bear risk.
In addition to controlling business performance,
managers must also monitor the external business
environment for impending changes or unexpected
events that may create either problems for the business
or new opportunities.
Summary
The approach to risk management described here
has four parts, namely goal setting, planning, imple-menting
the plan, and controlling business perfor-mance.
Goal setting provides direction, and the other
three parts describe the process of managing the
business to achieve these goals. Risk management is
a component of planning and implementing.
A manager must be aware of the many risks facing
the business and the importance of risk management in
achieving family goals. This includes an understand-ing
of the sources of risk and the impacts unfavorable
events can have on the business and family. This in
turn helps a manager to identify gaps in his or her
current risk management program and set risk
management priorities.
It is relatively easy to define and categorize a
number of risks and discuss risk management strate-gies
in general terms. However, the development of
risk management strategies imposes added costs and
makes added demands on a manager’s time.
Therefore, priorities must also be set between risk
management and other management functions.
Within the time allocated to risk management, the
manager must set priorities among the various
risks facing the family and farm and develop
specific risk management strategies for the most
serious ones. Outside assistance likely will be
required, because these decisions can be complex
and specific technical knowledge often is re-quired.
Clearly, managing a business in a risky envi-ronment
places high demands on a manager’s
time, energy and skills, but carefully developed
risk management strategies are the only way to
increase the likelihood that a business will
succeed.

NC State Economist
C O L L E G E O F A G R I C U L T U R E & L I F E S C I E N C E S
North Carolina Cooperative Extension Service
Employment and program opportunities are offered to all people regardless of race, color, national origin, sex, age, or disability.
North Carolina State University, North Carolina A& T State University, U. S. Department of Agriculture, and local governments cooperating.
Agricultural and Resource Economics • September/ October 1999
Managing Risk
Geoff Benson, Ph. D.
Associate Professor and Extension Economist
Introduction
Farming is and will always be a risky business.
As farm businesses have become larger, risk
exposure levels have increased significantly. This
is due to bigger investments, greater debt, and a
growing dependence on purchased inputs. Changes
in farm programs and trade policy have a direct
impact on farm businesses. New technology
frequently favors larger farms, which is one reason
farm numbers have declined. Moreover, new
technology may not always perform as advertised
or may not be profitable. Plus, the application of
new technology frequently demands sophisticated
management skills. All of these factors create
extraordinary demands on the managers of modern
farm businesses. How can a manager cope?
There is a time- tested approach that managers
can follow to enhance their chances of success.
This technique includes setting clear goals, careful
planning, possessing or obtaining the resources and
skills needed to implement the plan, and systemati-cally
monitoring and evaluating farm performance.
Monitoring and evaluating farm performance and
taking corrective actions when needed are some-times
referred to as controlling the business.
Planning, implementing, and controlling are the
three broad functions of management. Risk
management is an important component of the
planning and implementing functions.
If the manager of a business is to control risk,
he or she must have ( or must develop) a broad
awareness and understanding of risk and risk
management as well as an appreciation of the value
of incorporating risk management into the
planning and decision- making process. Risk
management includes an understanding of
sources of risk and the ability to evaluate the
impact of specific risks, the capability to set risk
management priorities, an understanding of risk
management strategies and decision- making
tools, and the ability to develop and implement
plans to manage specific risks.
Sources of Risk
Describing and categorizing risks in a mean-ingful
way can help a manager develop an
understanding of the sources of risk, which is
essential in the development of effective risk
management strategies. There are five funda-mental
sources of risk:
( 1) Weather and other natural phenomena.
Local weather affects yields and quality, both
directly through temperature and precipitation
and indirectly through impacts on pest popula-tions.
Global weather affects world production
and prices. Weather and other natural phenom-ena
can cause many types of natural disasters.
( 2) Technology. Technology is embodied in farm
operating inputs, for example, seeds and pest
control products and capital assets such as
machinery and buildings. The performance of
existing technology is not known with certainty.
The performance of new innovations is even
S T A T E U N I V E R S I T Y
A & T S T A T E U N I V E R S I T Y
C O O P E R A T I V E
E X T E N S I O N
H e l p i n g P e o p l e P u t K n o w l e d g e t o W o r k
N C
2 NC State Economist
more uncertain but, once established, may render
current farm practices and assets obsolete. Early
adopters of new technology take more risks because
new technology may not work under certain condi-tions
or may not be profitable. However, when new
technology is profitable, the early adopters earn the
greatest rewards.
( 3) Social attitudes. The attitudes and preferences of
society as a whole affect the demand for farm prod-ucts
directly, and indirectly they influence the many
and diverse government policies and regulations that
affect the agricultural economy.
( 4) Institutions. This encompasses a wide array of
government policies and regulations, the legal frame-work
of society and business, and industry structure
and performance. Government policies are pervasive
and include farm, trade, macroeconomic, and environ-mental
policies. Health and safety policies and
regulations affect productivity and cost. Laws
determine or influence business and economic behav-ior
by defining what is legal and what is criminal
activity, and laws affect business incentives and
opportunities.
( 5) Individual human behavior. This category
includes the skill level and knowledge of the primary
operator as well as key employees. It considers the
family situation ( health, personal relationships, etc.)
and also the behavior of third parties ( failure to fulfill
business contracts, negligence, criminal acts, etc.).
The sources of risk described above affect the
financial performance of the farm in a variety of
ways. These include impacts on production, prices,
profits, cash flow, and asset values. Farm profit is
defined as farm revenue less all economic costs. A
farm business must be profitable to prosper and
survive. Cash flow feasibility is the ability of the farm
business to meet its financial obligations in a timely
manner. This includes paying bills, making debt
payments and providing cash for family living needs.
Asset values affect the solvency of the business and
the ability to obtain credit.
If risks are to be controlled, the manager must
consider both the probability of an undesirable event
occurring and the nature and size of the impacts that
an event would cause if it did occur.
Setting Risk Management Priorities
Risk has two components: ( 1) the chance or
probability that an unfavorable event will occur, and
( 2) the impact of that event if it does occur. A
comprehensive approach to risk management means
assessing the potential impacts of the multitude of
risks faced by the business and then addressing these
risks in some order based on importance or signifi-cance.
Some risks have a low probability of occur-ring
and would have a small impact if they did occur.
Others may have a higher probability and a much
larger potential impact on the business.
To assess the financial consequences of various
risks on the viability of the business and the achieve-ment
of business and family goals, the manager must
have a sound grasp of the financial performance and
status of the business, which includes solvency,
profitability and cash flow.
Risk Management Strategies
The third component of risk management includes
strategies and tools for deciding what action to take to
manage a specific risk. There are three basic strate-gies:
( 1) Reduce the probability of an unfavorable event.
( 2) Self- insure and accept the impact if an unfavor-able
event occurs.
( 3) Reduce the impact on the business if an unfavor-able
event occurs by shifting risk to others.
Each category includes a large number of specific
actions to consider.
Reducing the probability of an unfavorable event
can be accomplished by effective strategic planning.
In particular, managers can develop their management
skills and increase their knowledge base either
directly through self- improvement or indirectly by
using outside advisors. Examples of effective strate-gic
planning include a thorough understanding of the
external environment within which the business
operates and of the trends and forces that could
change this operating environment in the future; an
understanding of the management process and of the
production processes of the enterprises that comprise
the business. ( This includes understanding past farm
performance, both physically and financially, and
September/ October 1999 3
knowledge of the current financial status of the
business. It also includes knowledge of the histori-cal
variability of key factors, such as yields and
prices.); skill development, which runs the gamut
from production skills through labor and financial
management.
All of these activities impose costs in the form
of time spent ( opportunity costs) and money.
Self- insurance includes the following options:
· Modify revenue- related risks by diversifying
the enterprise mix. However, this may lead to
lower average revenue or added costs through a
loss of efficiency.
· Reduce production risk by spreading production
geographically. This option is likely to cause costs
of production to increase.
· Build net worth. This will help a business
survive adverse events, but may also mean forego-ing
credit financed business opportunities or
reducing family living withdrawals.
· Build excess production capacity to reduce the
likelihood that production- related activities will be
delayed, reducing yields. This adds to costs,
including added investments in oversize or back- up
equipment and carrying extra labor.
· Establish a form of asset ownership and busi-ness
organization that optimally minimizes the
impact of adverse outcomes. This includes deci-sions
about leasing versus owning farm assets, the
proportions of equity and debt capital invested in
the business, and the legal basis of the business
organization.
Reducing the impact by risk transfer includes
buying insurance of one form or another including
indemnity insurance, life insurance, and multi- peril
crop insurance. Costs are incurred in the form of
insurance premiums. Hedging, options, forward
contracting, etc. can reduce price risk; but manage-ment
time is required, and there are transactions
costs.
For any given risk, there may be more than one
risk management strategy. In fact, there may be
several options under each strategy. The cost and
effectiveness of each option may be different, so
benefits and costs must be weighed. Furthermore,
the financial status and performance of the busi-ness
affects the choice of strategy. Decision
criteria and tools are needed to evaluate alternative
risk- management options. Many tools are available
such as sensitivity analysis, payoff matrices, risk- rated
returns, decision grids, and contingency planning.
Implementation
Most farmers have extensive experience implement-ing
the production part of a business plan. This includes
acquiring the resources called for in the plan — land,
facilities, equipment, and working capital. Implementa-tion
also consists of acquiring and managing human
resources, both hired employees and family. Imple-menting
a risk- management plan requires information
and skills in various areas such as production, market-ing,
financial, institutional, and human resource risk.
Evaluating and making timely decisions about specific
risks takes time and may be a continuous process, for
example, tracking market developments when using
futures to manage price risk.
Self- management is also necessary. It includes
taking the time to manage and develop all the skills
required of a manager including information manage-ment
and effective problem solving. An assessment of
past business performance, knowledge and skills
relative to managers of similar businesses may help an
individual manager determine his or her strengths and
weaknesses. This, in turn, may suggest areas where
professional development would be helpful, or where
assistance from outside professionals is required.
Controlling
Controlling is the third area of management. It
consists of monitoring farm performance and evaluat-ing
results against clearly defined standards or targets.
Evaluating performance regularly allows a manager to
identify problems early and take corrective action.
Minor problems may be easy to solve with a little fine-tuning,
but larger problems may require major changes.
Effective monitoring requires timely information
from a record keeping system designed specifically for
this purpose. The targets can be production related, for
example, per acre yields, animal growth rates or feed
conversion rates. Then again they may be financial,
such as prices received, cost of production per bushel,
return on investment, or income generated for family
living. Monitoring financial performance such as debt-
NC State Economist
North Carolina Cooperative Extension Service
North Carolina State University
Agricultural and Resource Economics
Box 8109
Raleigh, North Carolina 27695- 8109
4
NON- PROFIT ORG.
U. S. POSTAGE
PAID
RALEIGH, NC
PERMIT # 2353
N. C. State Economist
Published bi- monthly by the Department of Agricul-ture
and Resource Economics and the Cooperative
Extension Service. Address correspondence to:
The Editor, N. C. State Economist
Box 8109, N. C. State University
Raleigh, NC 27695- 8109
The N. C. State Economist is now on- line at:
http:// www2. ncsu. edu/ ncsu/ cals/ ag_ rec/
virtual_ library. html
to- asset ratios, net worth trends and cash flows will
show changes in the financial status of the business and
its ability to bear risk.
In addition to controlling business performance,
managers must also monitor the external business
environment for impending changes or unexpected
events that may create either problems for the business
or new opportunities.
Summary
The approach to risk management described here
has four parts, namely goal setting, planning, imple-menting
the plan, and controlling business perfor-mance.
Goal setting provides direction, and the other
three parts describe the process of managing the
business to achieve these goals. Risk management is
a component of planning and implementing.
A manager must be aware of the many risks facing
the business and the importance of risk management in
achieving family goals. This includes an understand-ing
of the sources of risk and the impacts unfavorable
events can have on the business and family. This in
turn helps a manager to identify gaps in his or her
current risk management program and set risk
management priorities.
It is relatively easy to define and categorize a
number of risks and discuss risk management strate-gies
in general terms. However, the development of
risk management strategies imposes added costs and
makes added demands on a manager’s time.
Therefore, priorities must also be set between risk
management and other management functions.
Within the time allocated to risk management, the
manager must set priorities among the various
risks facing the family and farm and develop
specific risk management strategies for the most
serious ones. Outside assistance likely will be
required, because these decisions can be complex
and specific technical knowledge often is re-quired.
Clearly, managing a business in a risky envi-ronment
places high demands on a manager’s
time, energy and skills, but carefully developed
risk management strategies are the only way to
increase the likelihood that a business will
succeed.